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Sunday, March 25, 2012

Bleeding won't cure Britain's debt malaise

Mar 23, 2012

New budget's focus on austerity steps can make a bad problem worse

By Andy Mukherjee

BRITAIN'S Chancellor of the Exchequer George Osborne appears to be a big fan of what Princeton University economist Paul Krugman likes to call the mediaeval practice of curing an illness by bleeding the patient - often to disastrous results.

The annual budget that Mr Osborne presented on Wednesday signalled the government's intention to carry forward - into its third year - a severe austerity programme that saw the public sector workforce in Britain shrink 7 per cent last year.

It is not that the 270,000 people the government fired last year got absorbed by a thriving private sector. Had that been the case, unemployment in Britain would not be at a 16-year high. Nor would the economy have contracted in the fourth quarter, stoking renewed concerns about another recession.

Even if a recession is avoided, the best possible outcome for the British economy this year will be a 'muddle through'. The government's growth target for the year is 0.8 per cent. The only strong pro-growth measure in Mr Osborne's budget was a reduction, from next month, in Britain's corporate tax rate to 24 per cent, from 26 per cent.

But the focus on austerity continues. Mr Osborne abolished some tax-free allowances for pensioners, a move that would rankle in an ageing society, especially as the top personal income tax rate of 50 per cent, applicable only to the wealthy, is being pared down by 5 percentage points.

Britain is sticking with austerity because the government sees it as key to 'the stability that the British economy needs and the low interest rates the British economy needs to allow the recovery to take hold', Mr Osborne said in a recent CNN interview.

That's just a wrong-headed argument.

There is no evidence to suggest that private creditors would have baulked at financing the British government's budget deficit in the absence of debilitating austerity.

British 10-year interest rates have declined to 2.4 per cent a year, from the 5.2 per cent level seen in June 2008. But that wasn't because of austerity. Interest rates in the United States, where the government continues to live well beyond its means, have also collapsed because of a 'safe haven' effect: a result of investors plonking their money into 'bonds of every advanced-country government that still has its own currency', as Professor Krugman puts it.

Consider the severity of the US debt challenge for a moment. Add up the existing US official debt and the present value of all future government expenditure. This liability exceeds the future value of all taxes the government is expected to collect in future by a staggering US$211 trillion (S$266 trillion), or 14 times US gross domestic product (GDP), according to Professor Richard Evans at Utah's Brigham Young University and his colleagues. Closing the gap will require all federal taxes to go up by a whopping 64 per cent. Even then, creditors' faith in the solvency of the US government is intact. Britain's challenge is not as severe.

To be sure, at about £1 trillion (S$2 trillion), or 63 per cent of GDP, Britain's public debt is not low. And this does not include the debt resulting from a takeover of Royal Bank of Scotland and Lloyds Banking Group. Adding the bailout debt pushes debt-to-GDP all the way to 148 per cent, though that's a trifle misleading: RBS and Lloyds obligations will disappear from the government's books when they eventually cease to be state-owned.

Unlike countries in continental Europe, Britain has its own currency. And the Bank of England does not share the European Central Bank's squeamishness about printing money to buy government bonds. Rather than make matters worse by pursuing stinging austerity, the focus of the government should have been on putting growth on a surer footing.

Fiscal belt-tightening is also proving to be a big drag in southern Europe where high unemployment rates and complete absence of a growth impetus are making it almost impossible for governments to improve their tattered balance sheets. Spain is struggling to cut its deficit; Greece's debt-to-GDP ratio may not stabilise for years to come. As a whole, the austerity measures are not working.

Economists at the International Monetary Fund (IMF) have put together a rich database on public debt. The database, which goes back to 1880, packs interesting historical evidence. In a recent study, the IMF researchers have discovered 11 episodes of meaningful reduction of public debt in the pre-World War I period. On average, a debt-to-GDP ratio of 89 per cent was successfully lowered to 62 per cent. Most of this improvement took place through fiscal austerity. Presumably this is the period to which Mr Osborne is looking for inspiration.

However, between 1945 and 1970, there were 17 episodes of even larger reduction in public debt, with average debt-to-GDP starting off at 92 per cent and sliding all the way to 33 per cent. In these post-World War II instances, economic growth played a large role. Indeed, in this period, growth contributed much more to helping lower public debt than conventional belt-tightening policies.

The IMF study does not say if growth or fiscal correction is a better solution to large government indebtedness, a problem that has once again assumed crisis proportions since the financial-sector debacle of 2008-09 forced Western governments to rescue their over-leveraged financial systems by assuming private debt on their own balance sheets.

A pragmatic approach for the British government would have been to commit to credible deficit-reduction strategies over the medium term, but it should have spared the economy pain in the short run.

Mr Osborne's budget shows that this simple lesson has not been learnt, and bleeding the patient is still the British government's preferred strategy for curing its debt malaise.